Student Loans Are Diving Underwater

The student loan market has a lot of factors that seem to say "Stay the heck away!": they're relatively easy to qualify for, college costs have increased far more rapidly than general consumer prices, we now seem to feel that EVERYONE SHOULD HAVE A COLLEGE EDUCATION. ELEVENTY!!!, and most importantly, the job outlook for many (most?) college grads is to put it mildly, pathetic.  

This graph from the Washington Post piece points out some evidence that we might be seeing the beginning of the next "bubble pop".  Although they're a fairly small part of the overall consumer loan market, student loans are more likely to be 90+ days past due than any other loan class.  And the percentage is growing pretty rapidly. 
 

Luckily, the Unknown Daughter gets free tuition at Unknown University.   We still have a half-dozen years until we have to shell out for college, but it'll take a lot to justify her going somewhere other than to my (fairly low-cost) school. 

Markets in Receivables

Here's an interesting article in the WSJ from a while back (7/16) titled "CIT's Woes Prompt Surge In Activity At Receivables Exchange".

CHICAGO (Dow Jones)--The turmoil surrounding finance giant CIT Group Inc. (CIT) is driving a surge in new business for a New Orleans-based company that runs a market in receivables.

The Receivables Exchange, which lets small- and mid-sized companies auction their accounts receivable to buyers that include hedge funds and commercial banks, on Wednesday recorded its busiest day ever and is fielding a flood of calls from businesses searching for financing alternatives.

"These people want to do their own underwriting and do their own credit determination," said Justin Brownhill, co-founder and chief executive of The Receivables Exchange, or TRE.

Events this week have shown that "they can't rely on others like CIT to do it," Brownhill said.

New York-based CIT, among the biggest U.S. lenders to small and mid-sized businesses, disclosed this week that it could face bankruptcy and won't be able to get help from the U.S. government.

The company is among the biggest names in the factoring marketplace, a $125 billion sector that functions as a middleman for short-term financing - paying vendors for goods up front and collecting full payment from retailers later.

It's a pretty neat example of how markets can be used as a solution to an old problem. Factoring companies have been around for quite a while, but typically dealt with firms with working capital needs on a one-to-one basis. Exchanges like these allow those companies to better diversify their portfolios and reduce their risk. At the same time, since it makes for multiple bidders, it could also extract some of the factoring companies' surplus and transfer it to firms selling their receivables (i.e. they get a higher price for their receivables).

Read the whole thing here (online subscription required, unless you find it through Google News).

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Cost of Corporate Borrowing is Up

Because corporate borrowing costs were low in recent years, many companies loaded up on debt. Now, much of that debt is coming due at a time when companies have experienced slowdowns. Here's a recent article from the NYTimes Online, titled "Cost of Borrowing Zooms up For Corporations":

Like consumers and homeowners, America’s corporations binged on easy credit when times were flush, racking up huge debts. Now the bills are due, and paying them back will not be easy, or cheap.

This year alone, more than $700 billion in corporate loans will come due, according to Standard & Poor’s. That is the size of the federal bailout of the financial sector. Many companies were counting on being able to borrow more money to meet those obligations and kick their debt farther down the road.

But with the credit markets still tight, corporations are being forced to pay much higher interest rates than they did a few years ago, putting more strain on balance sheets already hammered by falling profits and a grinding recession.

Read the whole thing here

Some Links On Distressed Debt Investing

One of my students is interviewing soon for an internship in an investment bank's fixed income department, and another is going to be starting soon in a credit analyst position, So, these pieces on distressed debt investing were pretty timely.

Michelle Harner over at the Conglomerate posted a very nice piece with some links about distressed debt investing. She highlights the difference between "vulture investing" and "investing for control" (basically traders vs. longer-term investors). She gives a couple of pretty good references. One, from Knowledge@QWharton lays out the basics of "distressed for control" investing:

Simply put, their line of work is to make a profit from companies that have failed to do so and are on the brink of bankruptcy. Unlike traditional hedge funds, however, their investment doesn't stop at buying significant portions of these companies' debt for pennies on the dollar, tidying up the balance sheet and then selling at a higher price. Instead, KPS and Matlin Patterson get in and stay in -- bringing in new managers, installing a new strategy, renegotiating labor and supplier contracts, and so on. (That's the 'control' part.) It's not an easy task, especially given the state of these companies when they step in.

Read the whole thing here.

She also cites some of her own research: a survey titled "Trends In Distressed Debt Investing: An Empirical Study of Investors' Objectives" (available on SSRN here).

Finally, Marketwatch gives us a look into the world of "vulture investors." It's a bit dated (April), but it shows how busy the world of distressed debt has become. One of the guys at my church's men's group is an analyst at a local distressed-debt hedge fund. He said he hasn't had this many good choices to buy since he can remember (luckily his firm is sitting on some cash).

I'm teaching the Level 1 Fixed Income material for CFA this spring, and will be teaching Unknown University's Fixed Income class in the fall. So, I'll probably be posting more on the credit market topics as time goes on (I tend to use this blog as a handy place to keep class-related stuff I want to remember).

Credit Default Swaps and Arctic Expeditions

This weekend I posted a video of a "whiteboard" talk by Paddy Hirsch of Marketplace, in which he explains CDOs and the credit crisis. Here's another one where he explains Credit Default Swaps (CDS) using the analogy of an arctic expedition.

Since I'm teaching Fixed Income next year, I'm sure some of these will make their way into my class.

One of The Best Explanations of the Credit Crisis I've Ever Seen

Every once in a while you come across an explanation that makes you realize that just really aren't all that good a teacher. Here's another one to add to the pile. In this video, Marketplace Senior Editor Paddy Hirsch gives one of the best explanations of CDOs and how they contributed to the current credit market woes that I've yet seen:


He's also got some other videos up on YouTube that I'll post in the next couple of weeks.

Fear Hits CD Market

I just heard an interesting story from a colleague (a former Wall Street lawyer who decided to become a lecturer at my university after retiring from his former career). I'm sure I'll be using it in class as an example of overreaction for the next few years (hey - I still talk about the Carter Years.

My colleague opened up his brokerage statement and noticed something verrrrry interesting (as Arte Johnson would have said).

He had two negotiable CDs - one from Washington Mutual and one from Lehman Bank. They originally had a 5-year maturity, but now had roughly 6 months until expiration, and were both under the FDIC limit. Here's the kicker - they were quoted at 92 and 93. In other words, you could buy them at 92% of face value, and would receive the full face amount at maturity 6 months later. This works out to a compound annual return of over 18% for the one quoted at 92, and about 15 1/2% for the one at 93. And this is for an FDIC-insured instrument.

So, he called his broker to see if there was an error. He was told that a significant number of people panicked when they saw the WAMU or Lehman name, and wanted to get out of their CDs at all costs. So, although the brokerage firm didn't advertise the fact, if my friend wanted to buy more CDs, he could have them at that price.

It's quite a story, and it illustrates how many people overreact in times of stress. 18% in a federally-insured instrument.

Simply amazing.

You can pick your frends, you can pick your nose, and you can PIK your bonds

Wednesday's WSJ had a very interesting piece on "PIK " or "Payment In Kind" bonds, titled "What's Aiding Buyout Boom: Toggle Notes." It's perfect to bring into the classroom if you're teaching about capital structure, M&A, financial engineering, or derivatives.

For the unitiated, a payment in kind toggle (I'll just call them PIK bonds from here on out) bond gives the issuer the option of not paying coupon payments. If they exercise the option (i.e. "flip the toggle"), the liability for the missed payments payments accrues (at an interest rate higher than the coupon rate) and is repaid at maturity. The article notes the recent PIK bond issued in the takeover of Neiman-Marcus - it has a 9% coupon, and a 75 basis point higher (i.e. 9.75%) rate on "toggled" payments.

In a Miller and Modigliani 1958 world, there aren't any costs to financial distress. In the real world, there are serious consequences to missing a coupon payment. Even more, actions taken to avoid this eventuality can cause distortions in firms investment and disclosure activities. So PIK bonds are a creative financial engineering solution to the problem.

It's not surprising that PIK toggle bonds have been seen mostly in the PE world. These deals end up highly leveraged. So, there's a significant risk that a target firm could get driven under by an external shock completely out of their control (the article uses 9-11 as an example). And the "insurance" seems pretty cheap at 75 basis points.

It's also interesting in terms of how you'd price the option. Since the option would be exercised if the firm was underwater on its debt payments, it's actually an option on the cash flows of the firm rather than on a traded security. Since the issuing firm has a much better feel for those numbers than the credit markets do, there should be a significant adverse selection problem with these securities. My guess is that the insurance (the 75 b.p. spread on the toggled payments) will turn out to be way too low.

There's some good commentary on the topic from the usual suspects: Abnormal Returns has a nice roundup of PE/credit related posts, and Going Private analyzes the effects of PIK financing on the PE firms equity returns.

And if you have no clue about what a PE firm is and does, here's a pretty good video primer on Private Equity from CNNMoney.com